chapter 12 · chapter 12 topics • what is money? • monetary intertemporal model • real and...
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Chapter 12 Money,
Banking, Prices, and Monetary
Policy Copyright © 2014 Pearson Education, Inc.
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1-2 © 2014 Pearson Education, Inc.
Chapter 12 Topics
• What is money? • Monetary Intertemporal Model • Real and nominal interest rates. • Demand for money – banks and alternative means of
payment. • Neutrality of money • Short-run non-neutrality of money • Zero lower bound and quantitative easing.
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1-3 © 2014 Pearson Education, Inc.
What is Money?
• Medium of exchange • Store of value • Unit of account
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1-4 © 2014 Pearson Education, Inc.
Measures of Money
• Monetary Base (outside money) = currency in circulation + bank reserves.
• M1 = currency in circulation + transactions deposits + travelers’ checks + demand deposits.
• M2 = M1 + savings deposits + retail money market funds.
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Monetary Aggregates, June 2012 (in $billions)
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The Inflation Rate
PPPi −
='
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1-7 © 2014 Pearson Education, Inc.
The Fisher Relation
iRr+
+=+111
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The Approximate Fisher Relation
iRr −≈
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Figure 12.1 Real and Nominal Interest Rates
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Banks and Alternative Means of Payment
• Assume all goods must be purchased with currency or credit cards.
• “Credit cards” can be assumed to stand in, more broadly, for debt cards and checks, for example – all alternative means of payment supplied by the financial system.
• Goods purchased at price P, no matter what means of payment is used.
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Banks and Alternative Means of Payment
• Using a credit card costs q per unit of goods purchased. • Credit supply (by banks) is given by Xs(q), which is
increasing in q.
• Supplying credit card services is costly for banks.
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Figure 12.2 The Supply Curve for Credit Card Services
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1-13 © 2014 Pearson Education, Inc.
Demand for Credit Card Services
• Quantity of goods purchased with credit card services: • Goods purchased with currency: • If then all goods are purchased with credit cards. • If then all goods are purchased with currency.
( )dX q
( )dY X q−
(1 ) (1 ),P R P q+ > +
(1 ) (1 ),P R P q+ < +
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Figure 12.3 Equilibrium in the Market for Credit Card Services
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Figure 12.4 The Effect of an Increase in the Nominal Interest Rate on the Market for Credit Card Services
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Demand for Money
*[ ( )]dM P Y X R= −
• Here, X*(R) is the equilibrium quantity of credit card services (decreasing function of R). Therefore, more simply,
),( RYPLM d =
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Demand for Money
• Increasing in real income – more currency required as volume of transactions increases.
• Decreasing in the nominal interest rate. The nominal interest rate is the opportunity cost of using currency in transactions – higher R implies greater use of credit in transactions, and less use of currency.
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Nominal Money Demand
• Substitute using the approximate Fisher relation. • For our experiments, suppose inflation rate is zero
(harmless).
),( irYPLM d +=
),( rYPLM d =
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Figure 12.5 The Nominal Money Demand Curve in the Monetary Intertemporal Model
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The Firm’s Labor Demand
• As in Chapter 4, the firm’s labor demand schedule is the marginal product of labor for the firm, which is downward sloping.
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Figure 12.6 The Effect of an Increase in Current Real Income on the Nominal Money Demand Curve
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Figure 12.7 The Current Money Market in the Monetary Intertemporal Model
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Figure 12.8 The Complete Monetary Intertemporal Model
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Figure 12.9 A Level Increase in the Money Supply in the Current Period
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The Neutrality of Money
• In the monetary intertemporal model, a level increase in the money supply increases the price level and the nominal wage in proportion to the money supply increase, but has no effect on any real macroeconomic variable.
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Figure 12.10 The Effects of a Level Increase in M— The Neutrality of Money
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Shifts in Money Demand
• These shifts are important for how monetary policy should be conducted.
• Shifts in the demand for money that occur within a day, week or month (the very short run) are a critical for the central bank.
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Figure 12.11 A Shift in the Supply of Credit Card Services
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Figure 12.12 A Shift in the Demand for Money
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Figure 12.13 Instability in Money Demand
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Sources of Shifts in the Demand for Money
• Shocks that the central bank is concerned with (in our model): shifts in money demand, output demand, output supply.
• Two alternative policy rules which central banks have adopted: money supply targeting, interest rate targeting.
• Key problem for the central bank: it cannot observe the shocks directly, and does not have timely information on all economic variables.
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The Short-Run Nonneutrality of Money: Friedman-Lucas Money Surprise Model
• Imperfect information: consumers know the market nominal wage, but they do not observe all prices simultaneously, so they do not know their real wage.
• Different aggregate shocks hit the economy – money supply shocks and productivity shocks – and consumers cannot observe these shocks directly.
• When a worker sees an increase in the nominal wage, what happened to prices?
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An Increase in the Money Supply in the Friedman-Lucas Money Surprise Model
• Money supply increases – unanticipated and unobserved by the private sector.
• Workers see an increase in their nominal wage, and think that their real wage has increased.
• Workers supply more labor, and output increases. • Nonneutrality of money, but only because people are
fooled into working harder.
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Figure 12.14 The Effects of an Unanticipated Increase in the Money Supply in the Money Surprise Model
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Money Supply Targeting and Interest Rate Targeting
• Basic money surprise model seems to indicate that predictability of the money supply is good policy.
• In the model, this means a constant M. In practice it means targeting the growth rate in the quantity of money.
• This works well for productivity shocks, but not for money demand shocks.
• For money demand shocks, interest rate targeting works well.
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Figure 12.15 A Surprise Increase in Money Demand in the Money Surprise Model
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Figure 12.16 A Total Factor Productivity Increase When There Is Interest Rate Targeting by the Central Bank
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Optimal Central Banking
• What tends to work well in practice is for the central bank to target a short-term nominal interest rate in the very short run, and to consider changing this target every few weeks.
• There is much volatility in money demand in the very short run – interest rate targeting accommodates this.
• Productivity shocks are slower moving – the interest rate target can change in response.
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Alternative Monetary Policy Rules
• Inflation targeting: Short-term interest rate target responds only to the inflation rate.
• Taylor rule: Short term interest rate target responds to inflation and to real aggregate activity.
• Nominal GDP targeting: Central bank attempts to target nominal GDP.
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The Zero Lower Bound and Quantitative Easing
• Zero lower bound: The nominal interest rate cannot go below zero, as that would imply an arbitrage opportunity.
• What happens when r = 0? At the zero lower bound there is a liquidity trap. Increasing the money supply through conventional means does not do anything – even prices do not change.
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Figure 12.17 A Liquidity Trap
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Figure 12.18 A Typical Yield Curve
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Quantitative Easing
• Under conventional accommodative monetary policy, the central bank swaps money for short-term government securities.
• But in a liquidity trap, this does not do anything. • However, long-term nominal interest rates can be positive
when short rates are zero. • What if the central bank purchases long-term government
securities? Won’t long-term interest rates go down?
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Does Quantitative Easing Work?
• Tried in the United States and in the U.K., post-financial crisis.
• Swaps of money for long-term government bonds and other long-term assets.
• Central bank hopes that this reduces long-term interest rates.
• Possibly, it does not. Does the central bank have an advantage, in a liquidity trap, in turning long-maturity government bonds into short-term liquid assets?